Monday, November 23, 2009

Risk Reversal or Synthetic Long Stock Position

A "Risk Reversal" or Synthetic Long position is where an investor will simultaneously buy and sell, out-of-the-money options with the goal of simulating a long stock position.  However, the goal of the synthetic position is to obtain much higher leverage, and reduce the down side risk.  After hearing the folks at fast money talk endlessly about this position, I decided to create a document so people can study it and think Quantitatively about it.  The full article is at: 

http://www.quantprinciple.com/invest/index.php/docs/quant_strategies/riskreversal/

Here is the Abstract:

Abstract
This article discusses a form of Financial Derivative investment strategy called a ‘Risk Reversal.’ A ‘Risk Reversal’ is also referred to as a ‘Synthetic Long’ in some literature. The article explains the theory, and shows you what risks you are exposed to. It also shows you how to protect your investment once the market has moved in a favorable direction. The theory, the mathematics and a theoretical example are presented. If you would like to contact the author, send a message to q.boiler@QuantP rinciple.com  . If there are any errors, typos, or defects with this article please make the effort to contact the author.


Once you have read the article please discuss below (good or bad!).
  

3 comments:

  1. Thank you for your article. I think the the first column heading in the last table of your article should read "price" as oposed to "price at expiration" as you are pecifiying an instantanious price shift in the underlying (I think).

    regards,
    Vincent O'Sullivan

    ReplyDelete
  2. You are absolutely correct, it is price or even price a long time from expiry. I will correct this. Thanks for your feedback.

    ReplyDelete
  3. What happens with a bearish risk reversal strategy if the sold call is being exercised before expiration? Do i have to deliver the associated stocks??

    ReplyDelete